The widely held expectation is that the Fed will raise rates at least three times again this year. The question becomes what does this mean for fixed income markets?
- Investors often seem to be under the notion that anything “bond” related is highly interest rate sensitive and will take a hit if rates rise—yet history has proven otherwise for certain fixed income asset classes.
- Looking at the actual returns for the high yield asset class, in the 15 calendar year periods since 1986 where we saw the 5-year Treasury yield increase (rates rise), high yield bonds posted an average annual return of 12.4% over those periods (or 9.2% if you exclude the massive performance of 2009).1
Higher coupons and yields in the high yield space help cushion the impact of rising interest rates.
- The higher the starting yield, the less impact we would expect to see from a move in interest rates.
High yield bonds have shorter durations than other asset classes in the fixed income space.
- Duration is a measure of the price sensitivity of a bond to changes in interest rates, which incorporates the coupon, maturity/call date, and price.
- High yield bonds are typically issued with five to ten year maturities and are generally callable after the first few years, as well as offer higher coupons, providing the high yield sector with a shorter duration, thus theoretically less interest rate sensitivity versus other asset classes.2
High yield bond returns are slightly positively correlated with changes in Treasury yields.3
- Certain asset classes, such as investment grade bonds have a negative correlation to changes in Treasury yields. This means if rates (yields) increase in Treasury bonds, we have historically seen investment grade returns move in the opposite direction (decline).
- However, high yield bonds are slightly positively correlated to Treasuries, so historically as Treasury rates increase, high yield bond prices and returns have seen little impact to an increase.
The price of high yield bonds have historically been much more linked to credit quality than to interest rates.
- Historically rates rise during a strengthening economy, and a stronger economy is generally favorable for corporate credit, as profitability and credit fundamentals often improve and default risk declines.
Rather than just assuming all fixed income products will be highly sensitive to interest rate moves, investors need to consider starting yields, durations, and correlations of assets, as well as the broader economic environment, as they assess interest rate risk and build portfolios. Should a higher interest rate environment persist this year in the face of a stronger economy, we would expect the high yield bond market to be positioned well.